Tuesday, October 30, 2012

What is Rajoy Waiting For ? Some Thoughts

Spanish Prime Minister Rajoy has continued to indicate that he will formally request more assistance when it is in the country's interest, which essentially means, when he is good and ready. And he is not now.

Following his meeting with Italy's Monti, Rajoy was quite candid. "The most important thing", Bloomberg quotes him saying, " is that the mechanism is there. He is acknowledging the actual value of the Outright Market Transactions (OMT) lies in its presence not operation.

Yet there is only so long that the market affections can be toyed with. The poor performance of Spanish bonds last week and the continued selling pressure today suggests investors patience is running thin. Draghi and the ECB had given Spain a reprieve in the form of the LTROs and the OMT.

Spanish bank deposits rose in September and anecdotal reports suggest a modest increase in foreign participation in the government auctions. Fitch's survey of the top ten US money market funds also found new exposure to European banks.

Rajoy is obviously and understandably reluctant to ask for broader assistance. And why should it? It still has access to the capital markets. That identifies the first condition that would likely force Rajoy's hand, namely, a dramatic rise in interest rates.

This is a distinct possibility, especially if one view the recent capital inflows as one-off adjustments, perhaps in part driven by benchmark/index considerations, as opposed to a reflection of new found confidence/optimism.
The risk-reward has also shifted. Spain's 10-year generic bond yield has ranged between about 5.0% and 7.75%. The Draghi-induced rally saw the yield more than 200 bp to the lower end of the range (~5.25%).
In addition, given the government's rosy forecast for only a 0.5% contraction next year, any signs of weaker growth trajectories could perversely weigh on bonds on account of the implication for the budget deficit. Typically, one expects weak or disappointing economic data to push yields lower, but in Spain, the dynamics may be overwhelmed by the fiscal impulses. Deeper economic contraction means large budget deficit and more debt.

The second condition that could force Rajoy's hand if he could not longer protect Spain's pensions. This is important in a country of 10 mln retired people in a country of 47 mln people.

It is the single biggest line item of the budget, accounting for 40% of spending and 9% of GDP (France 15% and Italy 13% for comparison). Given it size, it is clear that serious fiscal reform cannot take place without a discussion of pension. So far Rajoy has protected pensions in a way that Greece did not. In fact, the 2013 budget will fund a 1% increase in pensions by drawing down the fund's reserves.

Some reports suggest Spain's pensions also are part of the inter-generational transfer taking place. The government estimates that 1.7 mln of the 16 mln Spanish households have no salary income. Pensions in Spain appear to help support children and/or grandchildren.

Spain and Italy are on the same side of numerous debates in the euro area. They are both significant debtors and in the current environment this counts for a great deal. This is fine for the milquetoast joint press conferences, but below there surface there is a prisoners' dilemma game being played out and Monti is not cooperating.

It would be best for both if neither needed financial assistance.

Second best would be to ask jointly. Some Italian and French officials seem to think that if Spain were to formally request aid that it would help stabilize the financial markets. Monti may think Italy is being dragged down by Spain. However, the risk is that they are wrong: that if Spain gets assistance, the market, even if not immediately, will re-focus on Italy. What they do not seem to appreciate is the first mover advantage. A firewall is drawn and Spain in on one side and Italy on the other.

However, if Italy and Spain sought a precautionary facility simultaneously, it would reduce the stigma and be a stronger firewall. In fact, there might be nothing like a simultaneous French request in sympathy to solidify the firewall. France would not have to drawn on the line, of course. Precautionary lines of credit for Spain and Italy and France would do for sovereigns what the largely unused bilateral currency swap lines do for financial markets--ensured their ongoing operations.

The third permutation that might move Rajoy off the stick and on the ball is his friends in Europe would seek precautionary facilities at the same time. No one is talking about a package for Italy, but at the press conference after meeting with Rajoy, Monti again made a point of essentially saying that Italy was not Spain. It did not need assistance.

Given that Monti heads up an un-elected technocrat government, it would not appear he has a mandate to enter into a multi-year commitment with the Troika. However, a move in conjunction with Spain (and France), could be presented by multilateral initiative. An agreement with the Troika could help increase the odds that the successor government (next spring) does not unwind Monti's reforms.

It would allow Hollande to head up a faction to do what France an no longer do on its own and that is serve as a counter-weight to Germany. It would bring into better balance the interests of the creditors and debtors and sustaining that tension, without an all out victory for either side, is what it is all about.

Nor will the countries really be giving up anything that won't be taken away shortly. Schaeuble's proposal, endorsed by Draghi, for stronger and more invasive EU (Monetary Affairs Commissioner) oversight of national budgets, would further weaken fiscal sovereignty.

It is not clear what European officials mean when they say they will do anything it takes to save the euro. Does it mean asking for a precautionary facility? It is precautionary rather than reactive. The current strategy remains reactive. The Rajoy and Monti meeting was an opportunity to break this dynamic. If Monti (and Hollande) want Rajoy to take a package, there may be no better way to persuade him than by taking a package themselves.

The alternative, is succumbing to increased pressure, either directly through the markets, where the country faces record debt refinancing next year, or indirectly through the deterioration of the social fabric.

It is because Europe moves by crisis that the euro is may have to work its way lower still. Key support has been established near $1.2800 and there has been talk of official interest below $1.2900. Many suspect that the euro is in a lose-lose situation. The economic and financial fall out from US not being able to avoid the full force of the fiscal cliff is thought to make investors more risk averse, which is thought to help the dollar. Alternatively, the fiscal cliff is avoided or mitigate and a US recession is avoided, and the superior returns and unresolved European debt crisis weighs on the euro.